Understanding Financial Crises

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Questions and Answers

What economic event is considered the worst contraction since World War II?

  • The Great Depression
  • The Dot-com Bubble
  • The Financial Crisis of 2007 (correct)
  • The European Sovereign Debt Crisis

Which bank was sold to JP Morgan in March 2008?

  • Bank of America
  • Bear Stearns (correct)
  • Northern Rock
  • Lehman Brothers

What was one of the primary reasons for the rise in interest rates during the Eurocrisis?

  • High wages across the Eurozone
  • Increased foreign investments
  • Lower tax revenue from economic contraction (correct)
  • Increased consumer spending

Which organization was NOT involved in rescuing Greece during the Eurocrisis?

<p>World Bank (A)</p> Signup and view all the answers

What was a significant effect of the low interest rates from 2003 to 2006?

<p>Fueling of the housing bubble (A)</p> Signup and view all the answers

What crisis did AIG face in September 2008?

<p>Liquidity crisis (C)</p> Signup and view all the answers

Which country was the first to require a bailout during the Eurocrisis?

<p>Greece (B)</p> Signup and view all the answers

What was the immediate result of Lehman Brothers filing for bankruptcy in 2008?

<p>Loss of confidence in the markets (B)</p> Signup and view all the answers

What event during the Great Depression contributed significantly to agricultural decline?

<p>Severe droughts in the Midwest (A)</p> Signup and view all the answers

What was a primary characteristic of subprime lending during the Global Financial Crisis?

<p>Borrowers with lower creditworthiness gained access to mortgages (B)</p> Signup and view all the answers

Which tranche in a Collateralized Debt Obligation (CDO) is considered the highest ranked?

<p>Super senior (B)</p> Signup and view all the answers

What issue contributed to the failure of mortgage rating agencies during the financial crisis?

<p>Desire to maintain client relationships over accurate ratings (A)</p> Signup and view all the answers

Which of the following was NOT a result of the bank panics during the Great Depression?

<p>Expansion of credit availability (A)</p> Signup and view all the answers

What role did Special Purpose Vehicles (SPVs) play during the financial crisis?

<p>They were created to buy assets and sell them to investors (B)</p> Signup and view all the answers

What was a common problem with the underwriting standards in the US residential housing market leading up to the 2007-2009 crisis?

<p>Standards allowed nearly 100% financing (C)</p> Signup and view all the answers

What commonly happened to firms with productive uses during the Great Depression?

<p>They struggled to obtain financing (D)</p> Signup and view all the answers

What is a key characteristic of financial crises?

<p>Sharp decline in asset prices (D)</p> Signup and view all the answers

Which sequence accurately describes the initial phase of a financial crisis?

<p>Deterioration in financial institutions' balance sheets, asset-price decline, increase in uncertainty (D)</p> Signup and view all the answers

Which of the following is a consequence of deleveraging during a financial crisis?

<p>Scarcity of loans (D)</p> Signup and view all the answers

What typically causes a banking crisis within the context of a financial crisis?

<p>Decline in economic activity (D)</p> Signup and view all the answers

How does debt deflation impact asset prices and debt levels?

<p>Asset prices fall while debt levels remain unchanged (C)</p> Signup and view all the answers

What role does moral hazard play during a financial crisis?

<p>Increases risk-taking due to weakened safety nets (C)</p> Signup and view all the answers

Which of the following is NOT a way a financial crisis can initiate?

<p>Rise in investor confidence (B)</p> Signup and view all the answers

What is the primary effect of a stock market crash during a financial crisis?

<p>Initiates moral hazard issues (D)</p> Signup and view all the answers

Flashcards

Financial Crisis

A situation where financial markets experience a sharp drop in asset prices, leading to widespread firm failures and disruption.

Moral Hazard

A situation where a borrower takes on more risk because they know they are protected from the consequences of their actions.

Adverse Selection

A situation where lenders struggle to differentiate between good and bad borrowers because of limited information about their creditworthiness.

Deleveraging

The process where financial institutions reduce their lending activities, often triggered by losses or increased risk aversion.

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Asset-Price Boom

A situation where asset prices rise significantly above their fundamental value, often fueled by speculative buying and optimistic expectations.

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Asset-Price Bust

The event where an asset-price bubble bursts, leading to a sharp decline in prices, often resulting in financial distress for businesses and investors.

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Bank Panic

A situation where a sudden and widespread loss of confidence in the banking system causes depositors to withdraw their money en masse.

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Debt Deflation

A cycle where declining asset prices, coupled with high debt levels, create a downward spiral in the economy.

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The Great Depression

A situation where a normal economic downturn spirals into a severe economic crisis, often characterized by widespread unemployment, bank failures, and a decline in production.

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Subprime Lending

Loans given to borrowers with a higher risk of defaulting on their payments, often due to poor credit history or unstable income.

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Agency Problem in Mortgage Markets

A conflict of interest where a financial institution benefits from providing mortgages to borrowers even if those borrowers are likely to default.

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Collateralized Debt Obligations (CDOs)

A financial instrument that pools together multiple mortgages and issues debt securities (tranches) based on their risk levels.

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Special Purpose Vehicle (SPV)

A special purpose vehicle created to buy assets, package them into securities, and sell them to investors. Essentially, a financial intermediary that structures and repackages financial products.

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Super Senior Tranche of a CDO

The highest-rated tranche of a CDO, representing the lowest risk and receiving the last payment in case of defaults.

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Loose Underwriting Standards

The practice of lending money to borrowers with little regard for their ability to repay, often characterized by low documentation requirements and relaxed underwriting standards.

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Debt Overhang

A situation where borrowers take on more debt than they can afford, often driven by low interest rates and easy access to credit.

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Shadow Bank

A financial institution (FI) that provides loans but is not subject to the same regulations as traditional banks, such as hedge funds and money market funds.

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Study Notes

Financial Crises

  • Financial crises are major disruptions in financial markets, marked by a sharp decline in asset prices and the failure of firms.
  • The key to understanding financial crises lies in studying moral hazard and adverse selection, even though regulations are in place to mitigate these issues.
  • Financial crises follow a sequence:
    • Initiation: Deterioration in financial institutions' balance sheets, declining asset prices, and heightened uncertainty.
    • Banking Crisis: Economic activity shrinks, banking crises worsen the adverse selection and moral hazard problems, and lending contracts are affected.
    • Debt Deflation: An unanticipated decline in prices leads to a worsening of adverse selection and moral hazard problems, further harming economic activity.

Causes of Financial Crises

  • Credit Boom and Bust: Mismanagement of financial liberalisation or innovation can lead to a boom, but risks increase with weak incentives for risk management. Depositors may ignore risks, leading to losses and deleveraging.
  • Asset-Price Boom and Bust: A bubble inflates asset values beyond fundamental value. When the bubble bursts, prices fall causing net worth to decrease, raising moral hazard and triggering deleveraging.
  • Increase in Uncertainty: Major events like stock market crashes or financial institution failures cause uncertainty, triggering deleveraging.

Delevaraging

  • Delevaraging occurs when financial institutions reduce their lending activities.
  • This leaves no one to assess the health of firms, leading to financial system instability because the fundamental mechanisms to check adverse selection and moral hazard are gone.
  • Financial institutions face deteriorating balance sheets and insolvency, potentially leading to bank runs and declining asset prices, potentially leading to a debt deflation.

Cases of Financial Crises

  • The Great Depression: Stock prices doubled (1928-29) in the US before collapsing. Severe droughts in the Midwest severely impacted agriculture production, leading to credit troubles and bankruptcies for firms. Bank panics spread globally and impacted international trade.
  • Global Financial Crisis (2007-09):
    • Financial Innovation in Mortgage Markets: Subprime lending allowed less creditworthy borrowers to buy homes, but many couldn't afford the loans causing high defaults
    • Agency problems in mortgage markets: Banks didn't care if customers defaulted, leading to significant risk.
    • Role of asymmetric information: Credit rating agencies had meaningless ratings.
    • Collateralized Debt Obligations(CDOs): Bundled bad loans into CDOs, with the riskier parts given less favorable ratings
  • The European Sovereign Debt Crises(Eurocrisis): Before 2007, Eurozone countries had interest rate convergence. Afterwards, lower tax revenues and high public spending led to debt crises, with countries like Greece facing bailouts and affecting other countries.

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